March 24, 2017

Commercial Real Estate Finance Update – Winter 2017

Modern Funding has been on the conference circuit this winter meeting with commercial real estate lenders and investors across the country.  Conference locations have included Miami, San Diego and New York City, highlighting the diversity of our great nation and what attracts so much domestic and foreign capital, both personal and institutional, to our real estate markets.  Our takeaways can be summarized along three themes:

  • It’s still a great time to be a CRE borrower
  • Alternative lending is just lending
  • Innovation coming gradually to CRE Finance

Borrower-Friendly Commercial Real Estate Lending Climate Persists

Among the traditional sources of commercial real estate finance (banks, life insurance companies, Agencies, CMBS) lenders remain cautiously optimistic.  Different lender cohorts are feeling varying levels of regulatory pressure (CMBS especially) but the consensus prediction is that 2017 loan volumes would remain flat to slightly up relative to 2016.  Most pundits expect CMBS loan production to be down, while Agency and Alternative lenders increase market share.  Early 2017 has seen a fairly steep drop in investment sales activity, which could obviously affect lending volumes going forward.

In a sign that maybe the industry has learned from past indiscretions, most lenders are holding the line on leverage and borrower concessions relative to this part of the real estate cycle which is one of hyper-competitiveness.  Despite an increasing rate environment most lenders agree this will not have an adverse effect on real estate values.

Traditional construction lenders to large scale, luxury apartment developments are growing cautious, especially in certain markets like Miami and Manhattan.  In fact, construction lending generally is beginning to wane, as borrowers and lenders are starting to see the dampening effects of HVCRE.  Other caution flags are up around retail and suburban office, while lenders are more bullish on industrial properties and urban in-fill development in so-called “24-hour” cities.

One of the success stories in commercial and multifamily real estate finance has been the increasing share of “Agency” lending, especially their “small balance” programs which provide similar market-leading rates and terms as their conventional programs but with a simplified loan process and lower fees.

Alternative Lending is Just Lending

However they are categorized – “Alternative” lenders, “Non-Bank” lenders or “Private” lenders – this is a very broad category of CRE lenders that includes REITS, private equity funds, credit funds, family offices and even “the crowd.”  These lenders seek situations that are time sensitive where the ability to act quickly and creatively provides an advantage over traditional lenders who may be constrained by regulation, bureaucracy or credit policy.

Alternative lenders tend to focus on opportunities with the following characteristics:

  • Transitional Properties – tenant rollover or significant repositioning/renovation is required.
  • Subordinate financing – second or mezzanine position. Preferred equity is also popular product.

Alternative lenders prefer lending into special situations traditional providers of commercial real estate finance cannot, which affords them the ability to command higher spreads and fees.  In some cases they compete directly with the traditional lenders for very large construction and bridge loans in “core” real estate markets.

Technology Innovation in Commercial Real Estate Finance

We are still in the early stages of disruptive real estate finance innovation.  Marketplace lenders (MPLs) have begun the process of digitizing a complex business process, though most are focused on the less regulated “fix and flip” lending market.  These “business purpose” loans are a distant cousin of conforming residential mortgages and all of their compliance requirements.

Innovation in commercial real estate finance is not yet so evident.  Of the three parts of the loan production process (origination, underwriting and funding), the most noticeable advances have been on the funding side, where the many new lending platforms have facilitated the aggregation of debt and equity investment capital from thousands of accredited investors.  And now, through eREITS, passive investment in commercial real estate is open to all investors, not just accredited investors.  Whether this is a good thing for these small investors remains to be seen.

Commercial real estate lending is too idiosyncratic to scale solely via the application of technology.  Certainly parts of the origination and underwriting process can be greatly improved via the application of big data technology, but the cost of capital game will always be won by traditional lenders.

In the small business lending space, banks are beginning to partner with best-in-class online lenders, and ultimately the entire industry – bankers, platforms and ultimately borrowers – should benefit.  It will be interesting to see if incumbents and disrupters in real estate finance will start to form similar partnerships.